In 1944, under the Bretton Woods agreement, Western leaders created a global monetary system of fixed exchange rates. Currencies were fixed to the US dollar, which was convertible into gold at $35 an ounce.
By backing each dollar with gold, the US implicitly agreed to keep both the money supply and its trade deficit under control.
Initially, it worked. The US ran a trade surplus, helping it to maintain its gold reserves, and kept its debt under control. But during the 1960s, everything changed.
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Other countries recovered from post-war dislocation and steamed ahead, while the US ran a trade deficit, and the Vietnam War led to a surge in public spending and the money supply.
As a result, US gold reserves fell to the point where they were vulnerable to a sudden demand for redemptions. Things came to a head in 1971. West Germany decided to leave the gold standard and devalue its currency.
This put US exports at a disadvantage, at a time when unemployment was already high. It also shook confidence in the system, prompting more countries to exchange dollars for gold.
It became clear to the US that without a sudden cut in spending or interest-rate hikes, both of which were politically and economically impossible, the gold reserves would disappear.
So, President Richard Nixon took the drastic step of ending convertibility. To counter inflation, he ordered a 90-day wage and price freeze, and a 10% additional tax in imports, in anticipation that other countries would also devalue.
The move spelled the end of the fixed-exchange-rate system (formally wound up in 1973), and set the scene for the high inflation of the 1970s.
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